August 14, 2008

What’s Next for Short Sellers?

Earlier this week, the SEC’s emergency order (as amended) targeting naked short selling in the stocks of 19 financial institutions expired. In the coming weeks, the SEC is likely to propose rule changes that could extend the requirement to borrow or arrange to borrow securities prior to effecting a short sale to a broader range of companies, or to the market as a whole. In addition, last month the SEC reopened the comment period on proposed amendments to Regulation SHO (the SEC rules governing short sales). These developments set the stage for some revamping of the short sale rules this Fall, although it remains unclear just how much can actually be accomplished on this controversial topic as the election approaches.

Whether the emergency order helped or hurt Fannie Mae, Freddie Mac and the seventeen primary dealers that were covered by the order is the subject of some debate. In this New York Times piece, Floyd Norris notes mixed results. A recent WSJ article indicated that a majority of stocks covered by the emergency order saw fewer shares shorted in the latter half of July, although it is unclear how much of that is attributable to the actual (or psychological) effects of the order, or to broader market trends. A study released by Professor Arturo Bris at IMD in Switzerland notes that market quality deteriorated for the shares of the 19 companies covered by the order. Professor Bris states “Our preliminary findings show that the impetus for the SEC’s emergency order – that short selling was adversely affecting the performance of the 19 financial stocks – is groundless.” The study goes on to note that between July 21 and August 4, the shares of the 19 companies that were the subject of the order lost 3.83% of their value, or $60 billion.

So far, over 460 comment letters have been submitted in response to a comment request included in the Staff’s guidance on the emergency order, with a vast majority of those comments coming from individuals. This is a pretty amazing number of comments, given that the order was effective for only 23 days and the comments don’t appear to reflect any sort of form letter campaign (although a few commenters were apparently inspired to write in by CNBC’s Jim Kramer).

One thing is for certain when looking through these comment letters: short selling – and in particular naked short selling – inspires a great deal of investor anger and frustration. Many commenters expressed concern that the SEC has not adequately enforced the existing short sale rules, and many call for extending the emergency order to all stocks. Naked short selling has been a “populist” cause for some time now among smaller companies (and their investors), who have felt that they have been unfairly targeted – and in some cases destroyed – by naked short sellers while the SEC has done little to stop the practice. It now appears that the emergency order has raised the issue’s profile, grabbing the attention of a much broader cross-section of investors.

I think the SEC’s internet comment form has been a great innovation for soliciting comments from a broader range of interested persons, but the comments on the emergency order sometimes seem like they are better suited for a Yahoo Finance Message Board. One commenter remarks “[p]ersonally, I think that the entire SEC should be tarred and feathered for the job they have done over the years,” while this comment letter can be best described as a tirade and ends with the question: “And what’s the deal with not allowing exclamation points to be used in these comments??”

Nostalgia for the Uptick Rule

Many of those submitting comments on the naked short selling emergency order asked the SEC to bring back the “uptick” rule, which was eliminated last summer after a 70-year run. The rule was originally adopted out of concern about “bear raids” and their contribution to the 1937 market break (sound familiar?). While perhaps more of a symbolic gesture than an actual means of deterring short selling abuses, Rule 10a-1 had provided that, subject to some exceptions, a listed security could only be sold short at a price above the price at which the immediately preceding sale was effected (a plus-tick) or at the last sale price if it was higher than the last different price (a zero-plus tick). Short sales were not permitted on minus ticks or zero-minus ticks, subject to some limited exceptions. (Nasdaq had adopted similar restrictions via a bid test, since it was not an exchange at the time.)

Of course, last summer, when the uptick rule was abandoned, times were good – you could still get a mortgage without any income and you could fill up your SUV for under $3.00 per gallon – and the possibility of a prolonged bear market seemed remote. At the time, the SEC had concluded that the uptick test had modestly reduced market liquidity and did not appear to be necessary to prevent manipulation.

Today, a groundswell of support for bringing back the uptick test seems to be developing. Last month, Representative Gary Ackerman (D-NY), a member of the House Financial Services Committee, introduced legislation that would reinstate the uptick rule. Further, Chairman Cox has talked about the possibility of revisiting the rule. While bringing back the uptick rule is not part of the package of proposed amendments to Regulation SHO for which the comment period was recently reopened, the SEC will no doubt feel pressure to take another look at its decision on Rule 10a-1 as it delves into broader short selling issues over the next few months.

Are Covered Bonds the Answer to Mortgage Financing Woes?

Recently, Treasury Secretary Paulson stated that covered bonds “have the potential to increase mortgage financing, improve underwriting standards, and strengthen U.S. financial institutions by providing a new funding source that will diversify their overall portfolio.” Covered bonds are a special category of debt instruments that provide for recourse to the issuer or a “cover pool” of collateral that is segregated from the issuer’s assets. Covered bonds make up a $3 trillion market in Europe, and are now being looked out as a major financing alternative in the US.

In this podcast, Anna Pinedo of Morrison & Foerster discusses covered bonds, including:

– What is a covered bond?
– Why has the covered bond market in the United States lagged behind other markets?
– How do covered bonds differ from securitizations?
– What assets can be used to constitute a cover pool?
– What are the latest regulatory changes in the United States regarding covered bonds?
– What does the FDIC Policy Statement on Covered Bonds do for the market? What about the Treasury Best Practices?
– How have the covered bond markets responded to these regulatory changes?

– Dave Lynn